Pending Canadian income tax issues: December 7, 2005.

On December 7, 2005, Tax Executives Institute held its annual liaison meeting with officials of the Canadian Department of Finance on pending income tax issues. Reprinted below is the agenda for the meeting, which was prepared under the aegis of TEI's Canadian Income Tax Committee, whose chair is David V. Daubaras of General Electric Canada.

Tax Executives Institute welcomes the opportunity to present the following comments on income tax issues, which will be discussed with representatives of the Department of Finance during TEI's December 7, 2005, liaison meeting. If you have any questions about these comments, please do not hesitate to call either Monika M. Siegmund, TEI's Vice President for Canadian Affairs, at 403.691.3210, or David V. Daubaras, Chair of the Institute's Canadian Income Tax Committee, at 905.858.5309.

Background

Tax Executives Institute is the pre-eminent professional organization of business executives who are responsible--in an executive, administrative, or managerial capacity--for the tax affairs of the corporations and other businesses by which they are employed. TEI's 5,400 members represent more than 2,800 of the leading corporations in Canada, the United States, Europe, and Asia.

Canadians make up approximately 10 percent of TEI's membership, with our Canadian members belonging to chapters in Calgary, Montreal, Toronto, and Vancouver, which together make up one of our nine geographic regions. In addition, a substantial number of our U.S., European, and Asian members work for companies with significant Canadian operations. In sum, TEI's membership includes representatives from most major industries, including manufacturing, distributing, wholesaling, and retailing; real estate; transportation; financial; telecommunications; and natural resources (including timber and integrated oil companies). The comments set forth in this submission reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.

1. Late Elections

The Department has released draft legislation that would permit the late filing of a subsection 13(29) election; TEI welcomes its addition to the list of elections eligible for late filing. In the agenda for the 2003 liaison meeting with the Department, TEI suggested that the election under subsection 12(2.2) should also be made eligible for late filing in order to accord taxpayers the ability to net the refund of non-deductible interest expense against taxable income (on the assumption that CRA continues to assess taxpayers on the basis that a refund of a previously non-deductible item must be included in income). As an alternative, TEI recommended the Department consider an amendment to paragraph 12(1)(x) of the Act to exclude amounts "that were not previously deducted or deductible by a taxpayer." We invite the Department's reaction to the alternative proposals.

2. Deferred Capital Cost Allowance

Section 13 of the Act includes a two-year rolling-start rule that defers the deduction of capital cost allowance claims for assets that require a long construction or development period. The rule was adopted in 1991 during a period of substantial government deficits in order to defer the fiscal effect of taxpayers' capital investments. Even though the government collects substantial revenues from the taxes levied on the salaries of employees and profits of contractors during the construction or development of the assets, the recovery of the capital costs invested by the taxpayers whose payments are, in effect, funding those salaries and profits is deferred. (1) TEI recommends that the Department review the purpose of, and consider drafting legislation to repeal, the two-year rolling-start rule because it is a significant deterrent to capital investment in Canada.

3. Canada-United States Tax Treaty

A. At TEI's May 2005 Annual Canadian Tax Conference, representatives from the Department said that negotiations in respect of the Canada-U.S. Tax Protocol might be renewed soon and that the Department was readying its negotiating positions. Have the negotiations commenced? Would the Department provide an update on the status and the likelihood of concluding the current negotiations and finalizing a new agreement within the next 12 months? Is there anything that businesses can do to assist in expediting the negotiations to a successful conclusion?

B. We encourage the Department to develop, in consultation with stakeholders, and communicate a targeted strategy to phase out withholding taxes on interest and dividends (for both related and non-related party payments). Studies, such as the one prepared by the C.D. Howe Institute, have shown a strong link between increased foreign direct investment and the elimination of withholding taxes on interest and dividends. This is especially important in the context of the Canada-U.S. Protocol. The United States has eliminated (or substantially reduced) the required interest or withholding taxes in treaties with several of its trading partners (the U.K., Australia, Mexico, Japan, and Sweden). By eliminating dividend and interest withholding taxes under the Canada-U.S. treaty, Canada will be as competitive in respect of withholding taxes as the other jurisdictions for U.S. investments. Similarly, Canadian investors and lenders will have access to the U.S. market on terms as favourable as investors from those other countries.

4. Salary Deferral Arrangements

For various business reasons, many companies are replacing stock option plans with restricted stock unit (RSU) plans. The purpose of RSU plans is similar to stock option plans, i.e., to provide stock-based compensation that aligns employee goals and compensation more closely with shareholder interests. RSU plans, however, are generally easier to administer.

Regrettably, there may be tax impediments to establishing an effective RSU plan in Canada. Under the current rules, a salary deferral arrangement that includes a promise to pay that is actually paid in cash within three years is deductible by the employer when paid and taxable to the recipient when the payment is received. Where the vesting period of a salary deferral arrangement is longer than three years, CRA's interpretative position is that any instrument that (1) is "in the money" (has a value on the grant date, regardless whether the value can decline or be forfeited before realization) and (2) can be settled in cash at the employer's option is fully taxable to the employee on the date of grant, even where the employer does not deduct the payment until it is made. Where there is a significant risk of forfeiture, the deferred compensation is not taxable but in CRA's view a potential loss of employment during the vesting period does not constitute a significant risk of forfeiture.

To be effective, RSU plans are generally designed with vesting periods of longer than three years. Moreover, most such plans can be settled in cash or stock. As a result, employees would be subject to tax immediately on the grant of the RSUs under CRA's assessing position, but they likely would not have the cash available to pay the tax liability until the right is exercised. In addition, under the Sarbanes-Oxley Act, officers and directors are prohibited from borrowing from their employer, so companies are precluded from advancing funds to officers or directors to pay the tax liability prior to the actual exercise of the RSU rights and the receipt of cash to pay the taxes.

Would the Department consider legislation to change the definition of a salary deferral arrangement in order to exclude stock-based compensation that provides for symmetrical treatment on the timing of the deduction to the employer and the inclusion of the income to the employee? The Department seemingly supports a salary deferral arrangement where the deferred amount is paid in cash in less than three years. Similarly, a salary deferral arrangement with a term in excess of three years is acceptable where the compensation is settled in stock (or paid in cash only on the death or retirement of the employee). A salary deferral arrangement that falls between those two ranges but provides for symmetrical tax treatment between the employee and employer, however, seems to be offside. From a policy perspective, what is offensive about an alternative long-term stock compensation arrangement that is similar in effect to stock options?

5. Large Corporation Notices of Objection

TEI is concerned that the Large Corporation Notice of Objection rules can be administered in a fashion that would effectively deny taxpayers their right to appeal reassessments of their tax liabilities. Large file cases generally involve numerous complex issues of law and fact, but taxpayers can inadvertently lose their appeal rights because of a minor "foot fault" on myriad procedural requirements. Thus, TEI proposes that a working group of TEI members and Department representatives be established to discuss specific concerns about the Notice of Objection rules and their administration by CRA as well as potential legislative changes that would better balance taxpayers' fundamental due process right of appeal while preserving the Crown's interest in understanding the basis of a taxpayer's appeal. Indeed, a threshold issue would be to ensure that CRA provides adequate notice of the technical basis of its reassessment so that taxpayers can effectively comply with the Notice of Objection rules. Would the Department be willing to participate? (2)

6. Section 17(8)

There is a seeming anomaly in the application of paragraph 17(8)(a) of the Act in cases of indebtedness arising in connection with the acquisition by a controlled foreign affiliate (CFA) of the shares of another CFA where the acquired CFA shares constitute "excluded property." Assume that Canco (a taxable Canadian corporation) makes an interest-free loan to wholly owned CFA1, and CFA1 uses the funds to acquire shares of CFA2 (which shares are "excluded property" of CFA1). Paragraph 17(8)(a) excludes the loan amount from the operation of section 17 if CFA1 uses the proceeds to earn active business income or to make a loan to another CFA that satisfies the conditions of subsection 95(2). Paragraph 17(8)(a) does not, however, exclude a loan where the proceeds are used to directly acquire shares that are "excluded property" of another CFA in the same country. Would the Department consider recommending an amendment to paragraph 17(8)(a) to exclude a loan amount owing by a CFA where clause 95(2)(a)(ii)(D) would apply to any interest on the amount owing if the amount were owing to another CFA?

7. Restrictive Covenant Legislation

In October 2003, the Department announced that it would develop legislative proposals addressing the tax treatment of non-compete payments received by shareholders in connection with the sale of shares of a corporation. The narrowly targeted purpose of the proposals was seemingly to reverse the result in Fortino v. Canada, [1997] 2 C.T.C. 2184, and Manrell v. The Queen, 2003 F.C.A. 128, and prevent payments for such non-compete agreements from escaping taxation altogether. Regrettably, the definition of "restrictive covenant" in the Department's February 2004 draft of proposed legislation is extremely broad. Nearly every commercial transaction involves at least one party (and often both) promising to refrain from undertaking an action or exercising a right. As a result of the overbreadth of the rules, a large number of non-income and capital transactions would become taxable transactions, affecting the economics of every commercial transaction from routine small business loans to large, complex cross-border mergers. Where the parties to an agreement allocate no consideration to a restrictive covenant (and thus are clearly not attempting to use the Fortino doctrine to avoid taxation), what is the policy reason for subjecting the transaction subject to the restrictive covenant to taxation? We invite the Department's views on narrowing the scope of the draft legislation or providing appropriate exceptions for restrictive covenants where no payment or a portion of a payment is allocable to a restrictive covenant.

8. Regulation 105

Increasingly, business organizations staff their projects based on global skill sets rather than looking solely to the resources available within their home jurisdiction. Under Regulation 105, Canadian organizations must withhold taxes from payments to nonresident service providers. Similar withholding tax provisions, however, either do not apply in other jurisdictions or withholding waivers are readily granted and easily obtained. Moreover, nonresident suppliers to Canadian enterprises will frequently increase their prices (or require contractual indemnification from the service recipient) to offset the Regulation 105 withholding tax cost. As a result, Canadian service recipients bear both the costs of compliance as well as the economic burden of the withholding tax, thereby impairing the competitiveness of Canadian businesses in global service procurement. Would the Department provide its thoughts on the rationale for maintaining this regulation and advise whether it would consider taking steps to minimize the detrimental effect the regulation has on the competitiveness of Canadian businesses?

9. Statute-Barred Dates

Would the Department consider amending the "start date" for purposes of determining the statute-barred date for income tax assessments? Specifically, would the Department consider amending the start date to be the later of the due date of the income tax return or the date the tax return is actually filed? Adopting such a change would prevent unduly long periods for assessment of tax returns, especially where CRA fails to assess on a timely basis. The time period for reassessing large taxpayers is already one year longer than for other taxpayers and provides ample opportunity for CRA to audit the returns and issue reassessments.

In addition, would the Department consider instituting a limitation period for other tax returns filed by taxpayers, for example, for returns filed under Part XIII of the Act?

10. Loss of Contributed Surplus for Thin Capitalization Purposes Following an Amalgamation 

For purposes of calculating contributed surplus in the case of an amalgamation, paragraph 87(2)(y) of the Act provides that "the new corporation shall be deemed to be the same corporation as, and a continuation of, each predecessor corporation," but only for purposes of subsections 84(1) and 84(10). Thus, where a specified non-resident has previously contributed surplus to one or both predecessor corporations of an amalgamated company, the contributed surplus of the predecessor corporations seemingly does not flow through to the amalgamated company for purposes of the section 18(4) thin capitalization rules. In other words, the thin capitalization base is increased only to the extent surplus is contributed directly by a specified non-resident shareholder of the corporation and does not include indirect contributions by a non-resident predecessor to an amalgamated company. Would the Department consider an amendment to correct this anomaly?

11. Recent Court Decisions

Would the Department please provide its views on the implications of the recent Supreme Court decisions in Canada Trustco Mortgage Co. v. Canada (2005 S.C.C. 54), and Mathew v. Canada (2005 S.C.C. 55) (sometimes referred to as Kaulius, et al. v. The Queen) relating to the general anti-avoidance rules?

Conclusion

Tax Executives Institute appreciates the opportunity to present its comments in respect of pending income tax issues. We look forward to discussing our views with you during the Institute's December 7, 2005, liaison meeting.

(1) Under the long-term project election, some net present value cost recovery can be achieved for projects with a capital investment period of more than three years.

(2) Another issue for the group's discussion is the potential for eliminating the requirement to specify all consequential adjustments as well as the maximum quantum of relief sought (including amounts arising from the consequential adjustments) in the Notice of Objection. Many consequential adjustments are mechanical in nature and have no effect on the nature of, or the true amount in dispute between the taxpayer and CRA. The consequential adjustments are merely arithmetic exercises. The dollar amounts of the consequential adjustments, though, are nearly always contingent on the resolution of the disputed issues and, as such, are difficult to project because of the interaction of the unknown variables (i.e., the resolution the disputed issues that form the basis of the appeal) with the totality of the taxpayer's facts and circumstances.